M.M. Hypothesis: Assumptions and Limitations | Dividend Policy

After reading this article you will learn about the M.M. Hypothesis:- 1. Assumptions of M.M. Hypothesis 2. Limitations of M.M. Hypothesis.

Assumptions of M.M. Hypothesis:

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The assumptions of M.M. Hypothesis are:

1. (i) Perfect capital markets;

(ii) Investors are rational;

(iii) There are no transaction costs;

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(iv) Securities are infinitely divisible;

(v) No investor is large enough to influence market price of securities;

(vi) There are no floatation costs.

2. There are no taxes. Alternatively, there are no differences in tax rates between capital gains and dividends.

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3. A firm has a fixed investment policy which will not change over a period of time. Financing of new investments will not change in the required rate of return.

Investment Management:

i. There is perfect certainty by every investor as to future investments and profits of the firm. In other words; investors are able to forecast future prices and dividends with certainty.

According to the M.M. hypothesis, the crux of the matter is the “arbitrage process” or the switching and balancing operation. It also refers to the simultaneous movement of two transactions which exactly offset each other.

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The two transactions involved are paying dividends and raising capital through external funds either through the sale of new shares or raising additional funds through loans to finance investment programs.

Proposal I:

If dividends are distributed, an amount will have to be raised through the sale of new shares. The increased value per share through dividends will be exactly offset by the external raising of shares. The terminal value of shares will decline. Shareholders are indifferent between retention of dividend or payment, but they are interested in the firm’s future earnings.

Proposal II:

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If instead of raising equity shares the firm raises amount in the form of loan, there will be no difference between debt and equity because of leverage and the real cost of debt is the same as the real cost of equity. Therefore, according to the M.M. hypothesis, the dividend policy is irrelevant.

The arbitrage process also implies that the dividend pay-out ratio between two identical firms should be the same and so also the total value of the firm. The individual shareholder can invest his own earnings as well as the firm would, with dividend being irrelevant. A firm’s cost of capital would be independent of the dividend.

Finally, the arbitrage process the dividend policy would be irrelevant even under uncertainty. Market price of the firm should also be the same for two identical firms.

Step 1:

The market price of a share at the beginning of the period is equal to the present value of the dividends paid at the end of the period plus the market price of share at the end of the period.

Thus P0 = 1/(1 + ke)(D1+ P1)

P0 = current market price of share

ke = cost of equity

D1= dividend to be received at the end of the period

P1 = market price of the share at the end of the period.

Step 2:

Assuming no external financing, the total capitalized value of the firm would be the number of shares (n) times the price of each shares P0.

Thus, nP0= 1/(1 + ke)(nD1+ nP1)

Step 3:

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If the firm’s internal source of financing falls short, Xn is the number of new share issued at the end of year 1 at price P1.

Thus, nP0 = 1/(1 + ke)(nD1+Δn) P1-ΔnP1)

Equation 3 implies that the total value of the firm is the capitalized value of the dividends.

D = the change in the number of shares outstanding.

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n = number of shares outstanding for the period to be receiving during the period plus the value of the number of shares outstanding at the end of the period considering any newly issued shares less the value of the newly issued shares.

... Step 3 is the same as Step 2.

Step 4:

If the firm were to finance all investment proposals, the total amount of new shares issued:

DnP1 = I-(E-nD1)

DnP1 = I – E + nD1

DnP1 = The amount obtained from the sale of new shares to finance capital budget.

I = The total amount requirement of capital budget.

E = Earnings of the firm during the period.

ND1 = Total Dividends paid.

(En – D1) = Retained earnings.

Equation 4 states that whatever investment needs (C) are not financed by retained earnings, must be through the sale of additional equity shares.

Step 5:

If Step 4 is substituted into Step 3

Step 6

Since Dividend D are not found in Step 5, M.M. hypothesis concludes that dividends do not count and that the dividend has no effect on the share price. A company has an equity capitalization rate of 10%. Its currently outstanding shares are Rs. 20,000 selling at Rs. 100 each. The firm is planning to declare dividend of Rs. 5 per share at the end of the current financial year.

The company expects to have a net income of Rs. 2, 00,000 and proposes to make new investments of Rs. 4, 00,000. What will be the value of the firm’s share at the end of the year if (i) a dividend is not declared, and (ii) assuming that the firm pays a dividend how many shares must be issued? Use M.M. model to answer these questions.

(1) Value of the firm when dividends are paid

(a) Price per share at the end of year 1

P0= 1/(1 + ke)(D1+P1)

100 = 1/(1 + ke) (5+P1)

100 = Rs.5 +P1

Rs.105 = P1

(b) Amount required to be raised from the issue

DnP1 = 1 – (E – nD1)

= 4, 00,000-(2, 00,000-1, 00,000)

= 4, 00,000- 1, 00,000

= 3, 00,000

(c) Number of additional shares to be issued

Δv = 3,00,000/105 share = 2857 shares

Existing shares equals 20,000 + new shares 2857 = 22,857

(d) Value of the firm

mP0 = (n + Δ n)P1 – I + E/(1 + ke)

Or, Total number of shares X market price of the share = 22, 857 x 105 = 23,99,985 rounded of to Rs. 24,00,000 = value of the firm.

Thus, whether dividends are paid or not paid the value of the firm is the same.

Limitations of M.M. Hypothesis:

Modigliani and Miller have argued that it makes no difference to the investors if a firm retains earnings or declares a dividend. According to them, retained earnings and external financing balance each other.

Their assumptions appear to be unrealistic and unpractical although theoretically it is appealing. Some of the problems of MM approach are due to imperfect markets, transaction costs, floatation costs and uncertainty of future capital gains and the preference for current dividends. These are listed out.

Perfect Capital Markets:

MM model assumes that there are perfect capital markets. Such perfect markets do not exist in the practical world.

Floatation costs:

MM model assumes that there are no floatation costs and no time gaps are required in raising new equity capital. In the practical world, floatation costs must be incurred and legal formalities must be completed and then issues can be floated in the market.

Transaction Costs:

Although the model assumes that there are no transaction costs in the real world there is an expense leading to commission and brokerage to sell shares. Therefore, shareholders do have a preference for current dividends.

Taxes:

The model assumes that there is no tax. This assumption is not realistic as taxes have to be paid when shares are sold and there is a capital gain. Thus, investor prefers current dividends.

Uncertainty:

MM model states that a company is able to issue additional equity shares. This model is not valid when there is under-pricing or sale of shares at a price which is lower than the current market price.

This means that the firm will have to sell more shares if it does not want to give a dividend. In this condition, the firm should be retaining the profits and not pay dividends. Therefore, the model is not applicable in uncertain conditions.